The Dubious Tax Case Against Vanguard

Barry Ritholtz is a Bloomberg View columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He blogs at the Big Picture and is the author of “Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy.”Read More.

That was the case until this Newsweek headline in December: "Vanguard Whistleblower Could Get Billions in Tax Dodge Complaint." That was enough for me to get in touch with Vanguard’s PR and legal departments. As a lawyer, I already had formed views on this case, but I wanted to hear what Vanguard’s counsel thought of the claims. I had planned on letting this develop further, but a Sunday New York Times column by Jeff Sommer forced my hand.

But first, a disclosure: Vanguard is among the funds my firm uses; my wife’s retirement savings plan is almost all Vanguard; for Masters in Business, I have already interviewed Vanguard Chief Executive officer Bill McNabb and former CEO and Chairman Jack Brennan. And I am scheduled to interview Vanguard founder John Bogle next month. Make of my conflicts what you will.

However, as someone who graduated from law school and (however briefly) practiced law, I immediately scoffed at this lawsuit. The claims made under federal tax law as well as various state actions are dubious for a number of legal reasons, which we explain below.

None of these are super technical -- it is a simple process of looking at the intended purpose of the underlying legislation, as well as the obvious repercussions of a bastardized interpretation. Then there are the ethical issues of the whistleblower involved, and his pecuniary motivations.

The whistle-blower is David Danon, whose LinkedIn profile says that he worked at Vanguard as associate counsel from August 2008 until June 2013.

Vanguard was aware of the case when it was first filed under seal in 2013 (and made public a year later). A Texas Comptroller of Public Accounts audit which led to a "deficiency" discovery for the tax years 2010 to 2014 didn't at first seem related. Vanguard settled this by paying $2.3 million. It isn't unusual for a worldwide $3 trillion mutual fund family to have minor mistakes in tax filings, and my sense was that Vanguard initially assumed this was a normal tax error.

The Texas comptroller paid Danon about $117,000 for his role in that case, according to documents reviewed by Bloomberg News. Due to the confidential nature of the state whistle-blower rules, Vanguard at the time may not have been aware of the reason for the audit, or that a 5 percent reward was paid to Danon.

After that, Vanguard argued in other state cases that Danon was committing an ethical violation because he was barred from disclosing the firm's privileged information. The case was dismissed in New York, and at least so far, other state tax authorities have declined to pursue the fund giant.

It is noteworthy that while states pay a modest sum to whistle-blowers, the Internal Revenue Service reward is 30 percent of any penalty or settlement. The main federal legislation in question is Section 482 of the tax code. It notes its purpose is “to ensure taxpayers clearly reflect income attributable to controlled transactions and to prevent avoidance of taxes regarding such transactions.” (Emphasis added). Most of the IRS procedures and guidelines on 482 reflect its international nature. Essentially, 482 was designed to prevent sham offshore transactions that can be used to make normal profitable transactions seem unprofitable.

Vanguard Group has a structure that is more typical of insurance companies than mutual funds. As a mutual, Vanguard is owned by its individual funds’ shareholders, a structure approved by the Securities and Exchange Commission in 1981. The goal wasn't to avoid taxes, but rather to keep mutual-fund fees low for the benefit of its owners. The structure’s purpose was never intended as an offshore tax haven to hide profits.

I would say that it is a long shot that Vanguard will lose the IRS battle and have to charge investors higher fees as a result. Not only is this claim at odds with the obvious intent of the legislation, but it flies in the face of current policy initiatives. The entire motivation behind the Department of Labor's fiduciary rule changes is to lower the cost of saving for retirement.

I am with Yale law professor John D. Morley, a mutual fund structure expert, who was quoted in the New York Times as saying, “I consider this litigation a little silly.”

Not that Vanguard’s legal department wants or needs my advice, but it seems to me it might be worth exploring possible grounds for a countersuit. The ethical breaches alone seems like they deserve a stern rebuke. And the original lawsuit flies in the face of both prior SEC decisions and public policy. The federal court should throw out the underlying case.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Barry Ritholtz is a Bloomberg View columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He blogs at the Big Picture and is the author of “Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy.”Read more